When you want to start your own business, the very first thing you should consider is what kind of Business entity you are going to choose for your business. There are four different types of entity you could choose from; Sole proprietorship, C Corporation, S Corporation and Limited Liability Company. Prior to your selection, you must first consider the size and scope of the business, liability issues, income allocation, tax advantages & disadvantages, disclosures, and compliance requirements.
- Sole Proprietorship: As a self-employed, your income is reported on I.R.S. Form 1040, Schedule C. Self-employment tax is imposed on all earnings from a sole proprietorship in addition to standard income taxes. The owner of a sole proprietorship is personally liable for any debts incurred by the proprietorship.
- C Corporation: A common reason sole proprietorships change their entity to C Corporations is they want to separate themselves from debts incurred by businesses. Another reason is that they could benefit themselves with fringe benefits as owner-employee. A major disadvantage for converting it to C Corporation is double taxation; a corporation pays its income tax and when you receive dividend from corporation (after corporate pays its tax), you must pay income tax.
- S Corporation: In general, S Corporations do not pay any income taxes. Instead, the corporation’s income or loss is divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns; this lets shareholders to avoid double-taxation. To form an S corporation, all shareholders must be U.S. resident and number of shareholders cannot exceed 100. The dividend is exempted from self-employment tax, but as a shareholder and also an employee, shareholders should receive a reasonable amount of compensation.
- Limited Liability Company (LLC): Limited liability companies have gained their popularity recently because of following unique advantages.
a) Members (same concept as shareholders) have limited liability
b) Composition of members are not restricted
c) Income can be allocated per agreement between members
d) Income gets “pass-thru”, thus, is not applicable to double taxation.
Professionals cannot form LLC. Unless exempted by I.R.S. code, members are liable for self-employment tax.
Every entity has its own advantages and disadvantages. Therefore, an entity that best suits your situation should be selected after careful consideration.